Statement of Cash Flows

Credit Analysis Course for

Kuwait Investment Authority

Citibank

George Werner

This presentation was provided to Citibank by George Werner for the Kuwait Investment Authority Seminar. It is for educational purposes only and should not be
construed as investment advice or a recommendation with respect to any of the information presented. The content and views expressed in this presentation are
those of George Werner and are subject to change without notice. George Werner is not affiliated with Citibank.
This is confidential and proprietary information and may not be copied or reproduced.

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 Table of Contents

I. Statement of Cash Flows

II. Cash Flow from Operations (CFO)

III. Cash Flow from Investing and Financing

IV. Cash Flow Problem Areas

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I. Statement of Cash Flows

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 Purpose

• To provide relevant information about cash and cash

equivalent receipts and payments during a period by
categorizing the cash movements into three distinct
activities:
 Operations
 Investing
 Financing

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 Uses
• Reconcile net income and cash
• Separate cash from non-cash activities
• Assess ability of firm to meet cash obligations
• Assess potential future cash flows

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 Organized Into Three Activity Areas
• Operating activities
 Cash effects of transactions that determine net income
• Investing activities
 Making, collecting loans
 Acquiring, disposing of investments
 Acquiring, disposing of PP & E, other assets
• Financing activities
 Liability, Equity transactions

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II. Cash Flow from Operations (CFO)

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• Direct method
 Preferred by auditors
 Lists all gross cash receipts and disbursements
related to operations
 Gives a better measure of the size of cash flows in
both directions and gives more detail on certain
accounts indicating where a cash need might arise

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• Indirect method
 Usually allowed by auditors
 Starts with net income and adjusts for non-cash items
in order to convert to cash flow from operations (CFO)
 Preferred by analysts who project future cash flows by
first estimating future income levels

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• Most firms use the indirect method (cheaper and less revealing)
so credit analyst has to be able to convert as well as possible
• While a net CFO number is of less use for analysis than
information about the components and their magnitudes, it does
provide a better measure of performance than does net income,
as it is less subject to distortion. It is not distortion free, however
• Note: CFO has a financing, not profit measurement focus and is
thus suited to the evaluation and projection of short term liquidity
• The ability to generate cash from operations – the business of
the business – is an indicator of the firm’s true financial health

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 Direct Method

• In effect, the direct method presents net income as if

it were on a cash basis
 Cash collected from operations
less
 Cash payments for expenses
equals
 Cash income before taxes
less
 Cash tax payments
equals
 Net cash provided by (used in) operations
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• In the U.S., FASB requires a supplemental schedule
which reconciles this statement to net income, as well
as
 Cash collected from customers
 Interest, dividends received
 Other cash receipts
 Cash paid to employees, suppliers
 Interest paid
 Taxes paid
 Other operating cash payments

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 “Derived” Direct Method
• A proxy for the direct method (which requires access to
the transaction journal) is to calculate
 Sales - increase in AR
less
 (COGS + increase in inventories + decrease in AP)
less
 Interest paid and operating expenses (adjusted for
depreciation, amortizations, accruals and the like)
equals
 Cash income before taxes
less
 Cash tax payments
equals
 Net cash provided by (used in (if negative)) operations
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 Indirect Method
• This is the most widely used on a global basis

• Procedure:
 Determine the change in cash using beginning and
ending balance sheets
 Determine the cash flow from operations using Income
statement and beginning and ending balance sheets
 Determine the cash flows from investing, financing using
beginning and ending balance sheets

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• Net income
plus
 Depreciation, amortization, other non-cash
less adjustments
 Increase in accounts receivable
 Increase in inventory
 Increase in other operating assets
 Decrease in accounts payable
 Decrease in other operating liabilities
equals
 Net cash provided by (used in) operations

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• In addition, the firm must disclose
 Interest paid
 Income taxes paid

• The cash flow from operations calculated by

the direct method and the indirect method will
be (must be) identical

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III.Cash Flow from Investing
and Financing

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 Calculation

• The calculation of the cash flows from investing and

from financing then follows as
 Investing
~ Changes in non-operating asset accounts
 Financing
~ Changes in non-operating liability and equity accounts
• Adding the three components will (must) equal the
change in cash between the beginning and ending
balance sheets

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IV. Cash Flow Problem Areas

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 Cash Flow Problem Areas
• Adjustments, such as depreciation,
amortizations, bond discounts or
premiums, changes in deferred
taxes, change in equity in
undistributed earnings, etc.
• Accounts receivable and
Allowance for doubtful accounts
- Other working capital changes
e.g., dividends payable
• Gains/losses
– Need to be adjusted in
arriving at CFO
– Net, if indirect method;
– If using direct method,
adjust only when written off
– Separate changes that
result from operations from
other change
– Separate into investing
and operations
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• Pensions – Adjust for difference between
expense and funding

• Extraordinary items – All taxes paid are treated as

operating use;
– Extraordinary item is then treated
on a gross basis
• Significant non-cash – Do not appear in cash flow transactions
statement;
– Are disclosed in notes

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